Still too Big, still can’t fail

Wall Street Journal

The biggest banks are bigger than they were before the last crisis.

The 2010 Dodd-Frank law was sold as a way to prevent future bank bailouts. But so few people believe it that Sheila Bair, chairman of the Federal Deposit Insurance Corporation, has embarked on a campaign to convince the markets that next time really will be different. On Friday Ms. Bair sent a letter to Standard & Poor’s, the giant credit-ratings agency. S&P, like most of the financial community, suspects that Washington will open the checkbook again when Wall Street stumbles. Therefore the firm has given the largest financial institutions higher credit ratings to reflect this potential government support. Ms. Bair’s note assures S&P that she will put the wood to big banks and their creditors if they end up in the FDIC’s new resolution process for systemic firms. Therefore, she argues, the giant banks should no longer receive higher ratings, because Uncle Sam isn’t coming to their rescue. We guess the financial crisis really is over when a senior federal regulator feels confident urging downgrades of big banks. And on the merits, if Ms. Bair were the only Washingtonian with a say in this matter, investors might start to believe that the freedom to fail really has been restored.

But investors are still expressing a different belief. Recent data from the Federal Reserve and Ms. Bair’s FDIC confirm that the biggest banks still enjoy advantages over their smaller rivals, and by some measures these advantages have been growing since the July enactment of Dodd-Frank.

The FDIC data show how much banks pay to borrow money. One would expect that if Dodd-Frank really eliminated the possibility of government assistance for the largest banks and their creditors, then such creditors would be no more or less willing to lend to the big banks than to their smaller competitors. But in the second half of 2010, right after the passage of the law, banks with more than $100 billion in assets clearly enjoyed a lower cost of funds than banks in every other category. While the FDIC collects data on banks, the Federal Reserve collects data for bank holding companies. Its data only go through the third quarter, but they also show a funding advantage for the biggest players. And an analysis by Mike Mayo of Credit Agricole Securities (USA) shows that for all of 2010, the 10 largest bank holding companies, on average, paid 29 basis points less on interest-bearing liabilities than the next 40 bank holding companies. The FDIC concedes that big banks enjoy funding advantages, but not because the government will bail them out. The agency says the product mix at large firms helps them do especially well in low-interest-rate environments like the current one. The FDIC has a point. The big banks also enjoyed particularly cheap funding relative to competitors in the 2002-2004 period of very easy money. And whereas academic research once suggested that banks couldn’t draw much additional benefit from economies of scale once they had grown to a few hundred million dollars of assets, more recent data suggest that even the biggest banks can gain efficiencies as they grow and deploy automated systems across vast territories.

But the big guys have been enjoying free money for years since the crisis, and the benefits of scale for even longer. If Dodd-Frank was really working as advertised, wouldn’t the loss of special government protection create at least a competitive speed bump? Some claim that mandated capital raises after the crisis have made them a safer investment, but those changes were underway long before last summer’s passage of Dodd-Frank. What’s remarkable about the FDIC data is that the biggest banks seem to be accelerating through the first months of Dodd-Frank. Looking at the FDIC’s data on non-deposit, interest-bearing liabilities, the big guys’ funding advantage over the other banks in the second half of last year was even larger than in the first half—before the great « reform » was enacted. The funding advantage enjoyed by banks with more than $100 billion in assets over those in the $10-$100 billion range rose from 71 basis points in the first quarter to 78 basis points in the third quarter, which began with President Obama signing the bill and proclaiming an end to too-big-to-fail. The advantage increased to 81 in the fourth quarter. It’s good to be the kings of banking in a Dodd-Frank world. In a Wednesday visit to the Journal, Kansas City Fed President Thomas Hoenig said that the banking giants’ « huge » edge over their smaller rivals is due in large part to government support.

Yes, there is new authority for Ms. Bair’s FDIC to resolve large institutions, but will it even be used? In a recent speech, Mr. Hoenig noted that « there are important weaknesses with this framework. In particular, the final decision on solvency is not market driven but rests with different regulatory agencies and finally with the Secretary of the Treasury, which will bring political considerations into what should be a financial determination. » Mr. Hoenig reminded us that the biggest institutions are even bigger than they were before the financial crisis, and that he expects more bailouts of financial giants in the next crisis, regardless of « who the Secretary of the Treasury is. » That sounds right to us, which is also what the market is saying. Dodd-Frank is making the big banks bigger and more protected than ever against failure.